Many contingent liabilities do not appear in the balance sheet and instead are j

Question

Many contingent liabilities do not appear in the balance sheet and instead are just disclosed in the footnotes to the financial statements. Research one public company’s current financial statement and locate the footnotes on contingent liabilities. Provide an explanation of the types of contingent liabilities included in the footnotes. What is the GAAP accounting rule in order for a liability to be actually recorded and included in the balance sheet section? Why aren’t the liabilities you researched from the footnotes included in the liability section of the balance sheet? Why is it important for users of financial statements to read the footnotes and pay attention to the contingent liability section?

Explanation / Answer

Let us understand what are contingencies and the accounting treatment of contingencies as per US GAAP.

Under U.S. GAAP, ASC 450-20 defines a contingency as an "existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur”.

Thus, the actual result (whether it will be a loss or a gain) of a contingent event is not known at the time of preparation of the financial statements.

One of the conditions that must be met before an entity can accrue (provision in accounts) an estimated loss from a loss contingency is that "it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It may be noted that “it must be probable that one or more future events will occur confirming the fact of the loss”

Accounting treatment:

Contingent loss (liability) should be recognized in accounts if,

When both of these criteria are met, the expected impact of the loss contingency is recorded.

However, when it is not probable that the loss may occur or even if it is reasonably probable, if the amount of loss cannot be reasonably estimated, the amount of contingent loss need not be provided.

So, many companies take this as advantage and contend that future adverse effects from all loss contingencies are only reasonably possible so that no actual amounts are reported. Practical application of official accounting standards is not always theoretically pure, especially when the guidelines are nebulous.

Contingent liabilities, when not provided for in the accounts due to the above issue of estimation, should be included in the foot note to the balance sheet. Complete details of the nature of the event and description of the item and why it is not possible to estimate the financial impact of the event, should be disclosed. Also, what is probable and reasonableness of the estimation of the amount, have given scope to the management for subjective assessment and hence certain significant issues may not at all be provided in the accounts.

Hence, it is advisable for the users of the financial statement, to go through in detail, the foot notes to the balance sheet. It may throw light on the existence of a potential claim/loss, which if goes against the entity, may have the effect of seriously hampering the business.

The company analyzed for this purpose is “Pfizer” for the year 2016.

In annual report of Pfizer, one of the note to the balance sheet (Note 17 – Commitments and Contingencies), there are various items of contingent nature are disclosed.

One item is the legal proceeding against the company. The company expects that the probable loss and it has estimated the loss from the legal proceeding. It has also accrued the liability in the accounts.

Another note is;

B. Guarantees and Indemnifications In the ordinary course of business and in connection with the sale of assets and businesses, we often indemnify our counterparties against certain liabilities that may arise in connection with the transaction or related to activities prior to the transaction. These indemnifications typically pertain to environmental, tax, employee and/or product-related matters and patent-infringement claims. If the indemnified party were to make a successful claim pursuant to the terms of the indemnification, we would be required to reimburse the loss. These indemnifications are generally subject to threshold amounts, specified claim periods and other restrictions and limitations. Historically, we have not paid significant amounts under these provisions and, as of December 31, 2016, recorded amounts for the estimated fair value of these indemnifications were not significant.

As the amounts were not significant as per the management judgment, it had not provided.  

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